Understanding U.S. Venture Financing

Overview

SAFEs, priced rounds, pro-rata rights, and the terms international founders most often misread

U.S. venture financing uses a specialized vocabulary. Founders who focus only on valuation may overlook provisions that affect ownership, control, dilution, future financing, and exit outcomes.

A financing decision should be evaluated as a package. The amount raised, valuation, security type, investor rights, governance provisions, and dilution mechanics all matter.

SAFEs

A SAFE is a contractual right to receive equity in a future financing or other triggering event. It is generally not debt, does not usually accrue interest, and normally does not have a maturity date.

Common SAFE terms include:

• Valuation cap
• Discount
• Most-favored-nation provision
• Pro-rata rights
• Post-money or pre-money calculation
• Liquidity-event treatment
• Dissolution treatment

Valuation cap

The valuation cap determines the maximum valuation used to calculate the SAFE investor's conversion price.

A lower cap generally gives the investor more shares.

The cap is not necessarily the company's current valuation. It is a conversion mechanism.

Discount

A discount allows the SAFE investor to convert at a lower price than the new investors in the priced round.

When a SAFE contains both a cap and a discount, the conversion terms generally apply the mechanism that produces the more favorable price for the investor.

Post-money SAFEs

Post-money SAFEs make it easier to estimate how much ownership has been sold through the SAFE round before the next equity financing.

However, founders may underestimate dilution when issuing several post-money SAFEs. Each additional SAFE can dilute founders and existing holders while preserving the stated ownership represented by earlier SAFEs.

A company should model the entire capitalization table before signing each instrument.

Priced Equity Rounds

In a priced round, investors purchase preferred stock at a negotiated price per share.

The financing documents may include:

The financing establishes a pre-money valuation and a post-money valuation.

• Stock-purchase agreement
• Amended certificate of incorporation
• Investors' rights agreement
• Voting agreement
• Right-of-first-refusal and co-sale agreement
• Board and stockholder approvals
• Disclosure schedules

Pre-money valuation

The pre-money valuation is the negotiated value of the company immediately before the new investment.

Post-money valuation

The post-money valuation generally equals the pre-money valuation plus the new capital invested.

The founder's actual dilution may be greater than a simple pre-money calculation suggests if the financing requires an option-pool increase before closing.

The Option-Pool Shuffle

Investors often require the company to increase its employee option pool as part of the financing.

When the pool is increased before the investment, the dilution is generally borne by existing stockholders rather than the new investors.

Founders should evaluate:

A larger pool may be appropriate, but it should be tied to an evidence-based hiring plan.

• Current unused option pool
• Hiring plan
• Number of planned grants
• Expected grant sizes
• Timing of future financing
• Whether the requested pool is operationally justified

Liquidation Preference

Liquidation preference determines how proceeds are distributed in a sale, merger, or liquidation.

A typical structure may give preferred investors the right to receive their original investment before common stockholders receive proceeds.

Key variables include:

• Preference multiple
• Participating or non-participating structure
• Seniority among financing rounds
• Definition of liquidation event
• Conversion rights

Non-participating preference

The investor typically chooses between receiving the preference amount or converting to common stock and sharing according to ownership.

Participating preference

The investor may receive the preference amount and then also participate in the remaining proceeds.

Participating preferred stock can materially reduce founder and employee proceeds in moderate-value exits.

Anti-Dilution Protection

Anti-dilution provisions protect investors when the company later issues shares at a lower price.

Common approaches include:

Broad-based weighted-average protection is generally less punitive to founders than full-ratchet protection.

Founders should understand that anti-dilution protection does not prevent dilution. It changes the conversion rate of preferred stock when specified down-round conditions occur.

• Broad-based weighted average
• Narrow-based weighted average
• Full ratchet

Pro-Rata Rights

Pro-rata rights allow an investor to participate in future financings to maintain its ownership percentage.

Pro-rata rights can be valuable to investors and may be reasonable for significant participants. However, granting broad pro-rata rights to many small investors can make future rounds more difficult to allocate.

Founders should determine:

• Which investors receive the right
• Whether there is a minimum ownership threshold
• Whether the right applies to all future financings
• Whether the right can be transferred
• Whether there are exceptions for employee equity or strategic issuances

Board Control and Protective Provisions

Investors may receive board seats or board-observer rights.

Protective provisions may require preferred-stock approval for actions such as:

Founders should distinguish economic terms from control terms. A financing with a high valuation can still create significant governance restrictions.

• Selling the company
• Issuing senior securities
• Changing the certificate of incorporation
• Increasing authorized shares
• Incurring substantial debt
• Paying dividends
• Changing the size of the board
• Repurchasing shares
• Entering related-party transactions

Founder Vesting

Investors may require founders to remain subject to vesting or to restart a portion of their vesting schedule.

The rationale is retention. Investors want key founders to remain committed after the financing.

Negotiation points may include:

• Amount already vested
• Vesting commencement date
• Remaining vesting period
• Acceleration after termination
• Acceleration following a change in control
• Treatment of prior service

Terms International Founders Commonly Misread

International founders frequently misunderstand:

Every financing should be modeled under several scenarios, including:

The strongest financing is not necessarily the one with the highest stated valuation. It is the one that gives the company enough capital to reach the next value-creating milestone while preserving a workable capitalization table and governance structure.

• A SAFE cap as a guaranteed company valuation
• Post-money ownership calculations
• Option-pool dilution
• Liquidation preference outcomes
• Investor consent rights
• Founder-vesting resets
• Pro-rata obligations
• Conversion of foreign-company shares
• Tax consequences of restructuring
• The difference between board control and stockholder ownership
• Next-round dilution
• Down round
• Moderate acquisition
• High-value acquisition
• Founder departure
• Additional option-pool expansion